1/30/2006 @ 12:00AM

This Apple Is Too Shiny

The fashionable iPod has made Apple Computer beloved on Wall Street. But its success masks an erosion in the company’s profitability.

When final sales figures for the Christmas shopping season are tallied, look for shares of Apple Computer to get another boost. The world is in love with the iPod, and Wall Street is in love with Apple. Sales of the iPod’s newest version, the $299 video pocket player, are likely to top 4 million units for the first quarter, ended December 2005. That would add perhaps $142 million to the company’s pretax earnings, which were $1.8 billion in the most recent fiscal year.

The iPod, which has 76% of the MP3 music player market in the U.S. and 50% in Japan, has turned Apple into the kind of darling it was when it went public a quarter of a century ago. In the past four years Apple’s shares have climbed sixfold to $72, or 46 times trailing earnings. The hip brand image has infected the rest of the company’s product line. In fiscal year 2005 Apple sold 4.5 million computers, 38% more than it did the year before. Apple’s top line for the year ended September 2005 was $13.9 billion, better than double what it was four years earlier.

But this sales bounty masks a worrisome downward trend in profitability. Apple’s computer business, which contributes 45% of sales, has a gross margin of 30%, estimates Eugene Munster of Piper Jaffray; the iPod, with a 33% (and rising) share of sales, has a margin of only 20%. The other businesses linked to the iPod do little more than break even, analysts estimate: The iTunes Music Store earns at most 4 cents pretax on each 99-cent download for Apple, and iPod videos, which sell for $1.99, have a similar margin.

Apple’s iPod and music businesses are growing much faster than its computer business. Last year sales of iPods rose 248% to $4.5 billion, and sales of iPod services and accessories, like repairs and car chargers, rose 223% to $899 million. But computer sales were up only 27%.

It is highly likely under these circumstances that Apple’s overall gross profit margin will decline. Apple has been steadily lowering the average selling price of its pocket players, from $415 in 2001 to $188 last quarter. Says analyst Munster: “The newer markets for the iPod are more price sensitive.”

Apple declines to discuss the profitability of the different versions of the iPod. But in its financial statements the company says that it expects price competition to put pressure on gross margins for all consumer electronics industries and “especially for the iPod product line.” Aiming to stay two steps ahead of its rivals, Apple competes with itself. It stretched the first six iPod models out over two years but the last eight over only eight months. (Currently available are the Shuffle, the Nano and the video player.) This planned obsolescence has reduced the amount of time the company has to recoup its development costs on each product. The Nano, released in September 2005, has the lowest gross margin of any iPod, says Munster–about 18%.

Several of the 15 analysts with buy recommendations on Apple (a group that includes Munster) say the company could increase its profitability by cutting costs. But this is going to be hard to do. Apple has already reduced spending on research and development from 8% of sales in 2003 to 4% last year. In contrast, Creative Technology, number two in the MP3 market, with a 14% share globally, spends 7% of sales on R&D, as does Sony Corp. Apple’s overhead and selling costs have fallen from 20% of sales to 13% the past two years, well below Creative’s and Sony’s. And how can Apple cut much more from component costs? Apple has a deal in place through 2010 to get its flash memory from Hynix, Samsung, Intel, Toshiba and Micron. Memory is the most expensive element of the iPod 4GB Nano and accounts for two-thirds of the total parts cost.

Inspiring the bulls, Apple delivered fourth-quarter 2005 earnings of 50 cents a share, almost quadruple those of the prior year. But 12 cents of those earnings were related to one-time tax shifts. Without that shot in the arm Apple’s growth rate would have been half of what it averaged the previous three quarters. According to an analysis by Goldman Sachs, Apple’s return on invested capital peaked in the March 2005 quarter at 13.2%. In the September quarter this number fell to 9.7%. (Next earnings report was due Jan. 18, just after this article went to press.)

The bulls hope that the introduction of Intel chips into Apple computers this year will drive Apple’s share of the personal computer market from its recent 2.5% back toward the 10% it enjoyed 15 years ago. Another hopeful thought: Because only 8% of U.S. households own an iPod, Apple can sell a lot more.

But once you turn down the hosannas on the music player, you are left with a company with no hammerlock on the technology (Creative holds the patent to the interface for MP3 players) and no unique operational advantages (such as Dell’s made-to-order computers).

Founder-evangelist Chairman Steve Jobs has a cult following among certain computer users and the mostly worshipful attention of the business press. But it is unlikely that even his magic touch can alter the grim economics of consumer electronics gadgets: After a while they become commodities subject to vicious price competition. It happened to Sony’s color TV, to Motorola’s cell phone and to IBM’s PC. It takes a lot of guts to take on an icon like Steve Jobs, but Apple admirer Andrew Neff of Bear Stearns lowered his rating from a buy to a hold in mid-December.